Small Caps Suggest a Period of Sideways Trade

A week ago we thought we had a tiger by the tail. Small caps, which had lagged the market badly, led a broad move higher. The 52 week high list looked as healthy as it had since the October market top. We posted numerous suggested plays on our sister blog. We positioned ourselves for another market leg higher.

But by the end of the week the S&P small cap 600 had given up all of Monday’s gains and then some. While the major market indices have recently made fresh 52 week highs the small and mid cap indices have not. And in spite of a furious rally again this morning small caps are clearly stuck in a trading range. Without their participation market upside is likely to continue to be restrained and limited to a narrow group of stocks.

There are plenty of examples of markets that have based with narrow leadership after a considerable run, only to move smartly higher when conditions allowed. The key is to not get chopped up in range bound trading, caught trying to position yourself for a larger move only to get repeatedly stopped out.

Money can clearly be made in a narrow group of large cap stocks. The market is favoring them at present because they are likely to have international exposure. With better growth overseas than domestically and a steadily sinking dollar that magnifies repatriated earnings, growth opportunities are likely to be better than with small caps, which tend to have limited resources and sell mostly in their home market.

More specifically mining stocks of various stripes are outperforming as they price in reaccelerating growth in Asia and Latin America. So are the “pick and shovel” companies so necessary to their operations.

And BRIC country stocks are faring well as the worldwide bull market continues to be led by these bourses. Capitalization doesn’t matter in this instance as participation is broad.

But chasing this small leadership group can be dangerous. Given the narrowness of selection they are obvious to the market and thus increasingly crowded with late arrivals that will prove to be weak hands at the first sign of trouble.

If you can catch these stocks on a pullback to their 10 or preferably 20 MA’s they might yield satisfactory swing results. Otherwise managing positions with substantial gains and sitting on cash could continue to be your wisest course of action.

We find the stock selection of a major growth mutual fund of no small renown to be revealing. The Fidelity Contra Fund, long a leading growth fund in spite of its massive size, has McDonald’s (MCD) as one of its top 10 holdings. This large cap international company clearly fits our profile of a stock that is attracting investment dollars in the current market.

We don’t mean to disparage the fund’s stock selection or the stock in question, but MCD has posted single digit year over year earnings growth this year on single digit revenue declines. Obviously the fund is counting on a resurgent domestic economy as well as continued international growth to ramp up earnings and sales ahead of expectations in the coming year. They are probably right in their assumptions and likely to make money in the position. Just the same, it’s telling when this is what passes for a growth situation in what we are coming to define as the “new normal.”

And it’s another reason to curb your enthusiasm.